Why gold prices and US interest rates move in tandem

Every time the Fed announces a decision on the US interest rates, gold prices also react. If interest rates are increased, gold prices go down, and vice-versa, indicating a negative correlation. The explanation offered is that when interest rates rise, the higher returns attract foreign capital and demand for dollars. The higher demand for dollars raises the US dollar-exchange rate. This increased return on the dollar makes gold less attractive and, hence, the gold price falls.

This theory is what is put forward by television channels and economics courses around the world. For lack of a better phrase, one may refer to the above as the "Maggi Theory of Gold", that is, the theory is valid for the first two minutes of trading after announcement of an interest rate decision. Beyond that initial speculative sentiment, the historical evidence has been quite contrary to what is suggested by the above theory.

The Evidence

1971 was when the US went off the gold standard and thus, that would be a good starting point for this analysis. In January 1971, gold prices averaged $37/ounce and interest rates were 6.24 per cent. For the next 12 years, both increased gradually. Gold averaged $673 by September 1980, while interest rates peaked a year later, at 15.32 per cent.

For the next two decades, there was a bear market in the precious metal, in conjunction with declining interest rates. Gold prices bottomed by April 2001, at $260, and interest rates bottomed out by June 2003, at 3.33 per cent. From the bottom, both have been increasing steadily and, by June 2006, gold averaged $600, and the interest rate was 5.11 per cent

Indeed, barring very short-term time-frames, the correlation is actually a strongly positive one higher interest rates mean higher gold prices. But why is this so?

"Real" Theory of Gold

For one, gold is not an interest-bearing instrument. So "other things being equal", any interest-bearing instrument should be preferable. It does not matter whether the interest rate is 0.5 per cent or 50 per cent one would be worse off holding gold. So it is not the interest rate that influences gold prices, but the "other things" that is assumed to be equal.

So what are the "other things"? Let us get to the basics of investing to answer that. According to Benjamin Graham, "an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return". Most people would agree that it should at least be equal to the risk-free interest rate and a risk premium for holding a risky asset class.

But what happens when real rates of interest are negative? Then, an investment operation, even when it fits in with the above definition, would fail to maintain the purchasing power. So a more appropriate definition would be as follows: "An investment operation is one which, upon thorough analysis, promises safety of principal and a return that at least ensures maintenance of purchasing power over the period invested". Consequently, when expectations of inflation are high, investors prefer gold as a mechanism for protecting their purchasing power. Thus, when confidence in a currency is high (low inflation), then gold prices would be low and, for the same reason, interest rates also would be low. The best explanation for the gold standard was, ironically, given by the former US Fed chief, Mr Alan Greenspan, in his speech "Gold and Economic Freedom" in 1966:

"Under a gold standard, the amount of credit that an economy can support is determined by the economy's tangible assets, since every credit instrument is ultimately a claim on some tangible asset... The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which the banks accept in place of tangible assets and treat as if they were an actual deposit, that is, as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets."

Of course, the Maestro managed to unlearn this virtue by the time he reached the Fed, where he began the biggest money printing exercise ever witnessed. He did exactly what he had said would happen in the absence of a gold standard.

The effects of that can be observed in the Graph that shows how chocolate prices moved before and after the era of easy money. Chocolate is just an example, but it's true of almost every other consumer good. The Fed-doctored CPI or core rate will never tell you the true story.

Gold as leading indicator

While the positive correlation between gold and interest rates is obvious, the peaks and troughs do not exactly coincide.

If we plot gold vs 18-month future interest rates (that is, gold of January 1970, matched with the interest rate of July 1971), then the lines coincide almost exactly as shown in the Graph.

What this means is that the yellow metal has been a very good indicator of interest rates. Given the fact that gold has been going up sharply in the recent past, one can expect the interest rates to follow soon.

In an earlier article titled "The Inflation Game" (

Business Line

, July 21, 2006), this writer had explained why interest rates are set to increase. The current surge in gold just goes to confirm that.

The Golden Future

An interesting exercise would be to estimate how high the precious metal would go up in the next decade of rising interest rates. In the previous interest rate cycle of 1970 to 1983, prices went from $35 to about $675 (it touched $850 for one minute) an increase of nearly 20 times. This time around, we started from $260, so will we exceed $5,000?

One could argue that the gold price, as fixed by the US Government in 1970 at $35, was artificially low and, hence, the move appears exaggerated.

On the other hand, one could make a case that in every economic aspect fiscal deficit, consumer debt, trade deficit, debt-to-GDP, etc the US is much worse than it was during the 1970s and so gold could be headed for an even greater move.

A more fundamental reasoning would be that the 35-year (or 85-year experiment, as some Austrian Economists could rightfully claim, since we went off the true Gold Standard by 1920) experiment with the ultra loose monetary system with Fiat currencies has to end "eventually".

Subsequently, when we go back to the "Classical Gold Standard", Gold would have to be priced at $30,000 to account for the Dollars in circulation today. Thus, using a Gold standard to define the intrinsic value of Gold, $5000 would indeed be cheap.

XThese are paid-for links provided by Outbrain, and may or may not be relevant to the other content on this page. To find out more information about driving traffic to your content or to place this widget on your site, visit outbrain.com. You can read Outbrain's privacy and cookie policy here.